Report No. PID10469

Project Name NEPAL-Financial Sector Technical (@)Assistance Project

Region South Asia Regional Office

Sector Banking (100%)

Project ID P071291

Borrower(s) THE KINGDOM OF NEPAL

Implementing Agency

Address NEPAL RASTRA BANK

Address: Nepal Rastra Bank, Baluwatar,

Kathmandu, NEPAL

Contact Person: Governor, Nepal Ratsra

Bank

Tel: 977-1-410386

Fax: 977-1-410159

Email:

bkpromot@htp.com.np -

another email - nrbgov@mos.co.np

Ministry of Finance

Address: Ministry of Finance,

Bag Dubar, Kathmandu, NEPAL

Contact Person: Secretary, Ministry of

Finance

Tel: 977-1-259880

Fax: 977-1-259891

Email: facd_mof@gov.np

Environment Category C

Date PID Prepared November 14, 2002

Auth Appr/Negs Date January 22, 2002

Bank Approval Date December 19, 2002

1. Country and Sector Background

Financial Sector Background. Nepal has 15 commercial banks -- RBB, NBL, 9

Joint Venture Banks (JVB's), which are mixed public/privately owned, and 4

local banks. In addition, the sector also includes 2 large development

banks (the Agricultural Development Bank of Nepal (ADB/N) and the Nepal

Industrial Development Corporation (NIDC)), 48 finance companies, 13

insurance companies, numerous microfinance institutions, 7 Grameen

Replicator Banks, 35 financial cooperatives, 25 financial Non-Government

Organizations (NGO's), and a stock exchange. The two large banks -- RBB

and NBL -- account for around 50 percent of total banking system assets,

and are in a very precarious financial position. Political intervention,

weak management, disruptive unions, poor financial information systems,

and a deeply entrenched culture of non-repayment of loans has resulted in

a rapid deterioration of their financial health.

RBB, which represents 27 percent of commercial banking system assets, is

estimated to have a large negative net worth and therefore a capital base

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that is well below the levels required by generally accepted international

norms. Although in slightly better financial condition, NBL has similar

problems including a high negative net worth. This could have serious

ramifications for the Government in terms of systemic risk and could prove

to be a severe financial strain on an already delicate budget should

either of these two banks face a crisis of confidence with concomitant

adverse macroeconomic implications. A 2000 review of RBB and NBL

indicated that these banks together had estimated losses, as of mid-1998,

as much as $426 million -- equivalent to around 46 percent of the

Government budget or about 8.6 percent of GDP. The situation in these two

banks has inevitably deteriorated considerably since this date.

In general, Nepal's financial system suffers from the following problems

that are also recognized by the Government:

The Government's Role. His Majesty's Government of Nepal (HMGN) plays a

large direct role in the financial sector. From ownership of key

financial institutions such as RBB, ADBN, the Grameen banks, the insurance

industry, and, until recently, the Nepal Bank Limited (where it is still

the largest single shareholder); to significant influence over the Joint

Venture Banks; the Government's hand is evident in almost every aspect of

financial sector activity. This has resulted in strong political

interference in banking activities. This, in turn, has resulted in a weak

banking culture, non-repayment of loans, and poor financial health

throughout the system.

Nepal Rastra Bank -- the Central Bank. Until January 2002, when a new NRB

Act was approved, the NRB fell under the authority of the Ministry of

Finance. This historical lack of autonomy has hindered the NRB's ability

to supervise and regulate the banking system adequately. Political

influence in the RBB and NBL -- as well as their sheer dominance within

the banking system -- placed these banks outside the influence and control

of the central banking authorities. Although it may take time to become

fully operational, the new 2002 Act provides the NRB with sufficient

autonomy and full authority over the entire banking system. Recently

approved banking regulations will also provide the regulatory basis for

NRB to move the system closer to international banking norms while

permitting the bank supervisors to deal expeditiously with errant banks.

For the immediate future, the NRB's challenge will be to enforce the rules

that have now been established.

The Government and the NRB need to reorient their activities away from

being active participants (as owners and operators) in the financial

sector to increasingly focus on becoming more effective regulators and

supervisors.

Rastriya Banijya Bank (RBB) is 100 percent Government owned. As the

largest commercial bank, with more than 200 branches, RBB has an important

role to play in the economy. However, burdened by political demands, an

active and disruptive union movement, management weaknesses, poor

accounting and auditing functions, and high levels of non-performing

assets, RBB has reached a particularly parlous financial state. A recent

audit points to a high negative net worth, weak internal systems, poor

internal financial management, and shabby operating methods. At the

request of the government, a diagnostic review of the RBB and NBL was

carried out by KPMG/Barents in 1999/2000. This study's major findings

confirm that (a) the banks' management is basically dysfunctional; (b)

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there are no reliable data available on the loan portfolio; (c) financial

accounting is primitive and not according to international standards

(accounts are virtually all manual and annual statements have not been

produced for over six years); (d) business strategies are not in place;

(e) human resource policy is weak and counterproductive; (f) management

information systems and record keeping are very basic; and (g) governance

and management are highly politically driven and lacking a commercial

focus. This work was financially supported under a Policy and Human

Resources Development Fund (PHRD) grant (TF 025473) for both RBB and NBL.

The Nepal Bank Limited (NBL). While in somewhat better financial

condition, NBL is still a weak institution. Its dominant role in the

financial sector creates scope for inefficiency and a low level of banking

competition. Over the 1990s, the Government reduced its stake in NBL by

selling parcels of shares to the private sector. The Government has

reduced its shareholding to a minority 41 percent, although it remains the

single biggest shareholder in the bank. This disinvestment by HMGN was

carried out with the objective of reducing political interference in NBL's

management and promoting private sector participation in the bank so that

it could operate in a more commercial and business-like manner. The

Government's policy of successively selling shares to the general public

has, however, left the bank without a single strategic partner with a

strong background in commercial banking and international linkages with

the global economy. Insider dealings and other inappropriate activities

by the new private owners are thought to have further compromised its

operations. As such, it also has many of the same problems as RBB (see

above) as identified in the KPMG diagnostic.

The Agricultural Development Bank of Nepal (ADB/N). The financial and

operational situation of the ADB/N, the third biggest bank in Nepal, is

also poor. The ADB/N will require restructuring, system development,

changes in governance arrangements, and a review of its ultimate role and

ownership arrangements. This bank is being dealt with by the Asian

Development Bank. Close coordination between IDA and the ADB mean that

actions taken in RBB and NBL are likely to be applied to ADB/N to ensure a

consistency of approach.

A Weak and Fragmented Legal Financial Environment. Nepal has a

proliferation of both laws and regulations that are institutionally rather

than functionally focused. This has created a fragmented legal

environment.The Nepal Rastra Bank Act, now superseded by a January 2002 Act, was

seriously outdated and deficient with respect to issues of central bank

autonomy, accountability, and governance. Now that new legislation has

been approved, the challenge will be to ensure that NRB can effectively

enforce the provisions of the new legal and regulatory environment.

The 1974 Commercial Bank Act is also defective. Most importantly, the act

does not cover all deposit-taking institutions. Other nonbank

deposit-taking institutions are governed by their own laws -- the

Development Bank Act of 1996, the Agricultural Development Bank Act of

1967, and so on. A proliferation of laws covering various classes of

deposit-taking institutions has permitted legal arbitrage. NRB has

recently completed drafting a new Banking and Financial Institutions Act

that covers all major deposit-taking institutions. This Act is expected

to become law in 2003.

Ancillary Laws. Once the above two key pieces of legislation have been

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amended, it will be important to ensure that other ancillary laws are

developed in support of a modern banking system. New legislation is

required in such areas as collateral, credit activity, bankruptcy law, and

so on.

A Weak and Fragmented Accounting and Auditing Environment. A weak

accounting and auditing tradition has meant that the timeliness and

reliability of financial data (particularly from the largest banks) is

extremely poor. Corporate sector accounting is also weak, making lending

decisions difficult for the banks. If Nepal's financial system is to

operate in a prudentially sound and efficient manner, strengthening of

accounting and auditing is essential.

Competition in the Banking Sector. Reform of the state-owned banking

sector should be designed to reduce fragmentation and support the more

efficient intermediation of funds within the banks and nonbanks. This

would increase competitive pressures and thereby provide more efficient

and cost-effective solutions to the banking public. Market-oriented

approaches also need to be developed to enhance competitive pressures.

These are preferable to mandated efforts such as those developed to

control interest rate spreads and priority and deprived sector lending.

Other Issues. In addition to the above, the financial sector environment

needs to be strengthened in several fundamental ways. For example, credit

information systems have not been effective tools against non-performing

borrowers; capacity building in the sector remains very weak; and the

general public's low level of financial sophistication means that it does

not serve as an effective check and balance within the system. These

weaknesses also require attention.

These issues call for urgent reform and modernization. Nepal needs to

create the preconditions for the development of an efficient banking

system that is capable of developing new financing mechanisms and

instruments to meet private sector needs. Without such reforms, the

prospects for faster growth and ultimately poverty reduction will be

constrained. However, financial sector development is a long and complex

process that will take many years, particularly given the very low

starting point in Nepal. The proposed program will start this process and

deal with only the most serious of these problems -- specifically central

banking, the two largest banks, and strengthening the financial

environment.

Government Strategy. Over the past few years, the Government has

undertaken general reform measures in the financial sector. These include

interest rate deregulation, the phase out of Statutory Liquidity

Requirements (SLR), introduction of modern banking regulations, capital

market reforms, and foreign exchange liberalization. However, much

remains to be done, particularly with respect to institutional reform. To

help establish a framework for the way forward, the Government has

formulated a Financial Sector Strategy Statement (FSSS) that consolidates

its thinking and develops a comprehensive and interlinked reform program.

The FSSS has been discussed widely within Nepal -- within the private

sector and the financial sector -- and it has been adopted as Government

policy. The FSSS was publicly released and published in the Nepali and

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English press at the end of 2000. The desire for reform in the financial

sector is further reflected by the fact that the Government has asked for

World Bank, IMF, and Department for International Development (DFID)

assistance to proceed with the reform agenda. Initial support has been

provided through a PHRD grant and a Project Preparation Facility (PPF).

The main elements of the HMGN's FSSS sector strategy include:

Reduce the role of the Government in the financial sector as a direct

owner of financial institutions while strengthening its role as a

supervisor and regulator of banks and financial institutions;

Require strong corporate governance by ensuring that banks (in particular

the two largest commercial banks) are owned and managed by "fit and

proper" private investors;

Strengthen the role of Nepal Rastra Bank in the overall financial system

by drafting a new Act to provide sufficient autonomy in the conduct of

monetary policy, banking system regulation and supervision, and the

licensing of banks and nonbanks;

Improve existing banking and financial legislation and judicial processes

for enforcing financial contracts;

Improve auditing and accountancy standards within the banking sector; and

Promote financial discipline through adequate disclosure and competition.

The reforms in the financial sector, particularly with respect to the

state-owned banks, require strong political commitment. As in many

countries, bank restructuring issues are likely to be difficult for the

Government when the time comes for action. For example, although

liquidation of RBB is one of the options that will be considered, this may

not be politically acceptable. Even privatizing the bank to good

foreign-banking interests or splitting its activities into several

distinct components may prove difficult to implement (given its poor

financial health, its long public-sector association, and the weak state

of the Nepali economy). Nonetheless, fundamental reform is required and

strong political commitment will be necessary if the reform measures are

to be carried through to a point where they make a lasting and

irreversible contribution to overall economic development. Government

commitment to reform, to date, has been demonstrated by its contracting of

KPMG to assess future options for RBB and NBL; the installation of a

professional management team in NBL in July 2002 and a CEO in RBB in late

2002; development of a modern legal and regulatory environment for

banking; and the issuance of an overarching Government policy on financial

sector reform. These activities provide the World Bank with comfort that

the Government is willing to transparently assess the condition of the

banks and to develop credible corrective action plans.

2. Objectives

The overarching objective of the Reform Program in the Financial Sector is

to support the renewed efforts of His Majesty's Government of Nepal (HMGN)

to improve the sector in order to bring macroeconomic stability and

promote private-sector-led economic growth. The proposed Financial Sector

Technical Assistance Project is the first major step in this process and

focuses on three broad objectives (a) helping to restructure and

re-engineer the Central Bank (Nepal Rastra Bank - NRB), so that it can

effectively perform its key central banking functions; (b) commencing

commercial banking reform in the two large ailing commercial banks that

dominate the sector (Rastriya Banijya Bank (RBB) and Nepal Bank Limited

(NBL)) -- by introducing stronger bank management that protects the

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financial integrity of the two banks and would take on a conservator role

to prepare the banks for the next steps of restructuring; and (c)

supporting a better environment for financial sector reform in areas such

as enhanced credit information, better financial news reporting, and

better training for staff in financial institutions. These actions will

help create a more prudently operated and commercially viable commercial

banking system that is overseen by a modern, effective, and technically

competent central bank. If sufficient progress is made during this first

phase of reform, then subsequent IDA support would focus on more longer

term objectives. These include further deepening and broadening of the

sector, supporting worker retrenchment in the banks, bank privatization

and/or liquidation, and helping to cover the financial losses in the large

publically owned banks.

It is anticipated that IDA's support for the overall financial sector

reform program will be in the form of several, sequential projects. The

first of these -- the Financial Sector Technical Assistance Project -- is

centered around the re-engineering of Nepal Rastra Bank (particularly in

its core central banking functions; supervision, monetary policy, banking

legislation, accounting and auditing, information technology, human

resources, and training); reform of the two large commercial banks -- RBB

and NBL (through the recruitment of Management Teams to put these two

banks in conservatorship on behalf of the central bank); and support for

capacity building in the financial sector (through support for training,

financial journalism, and a credit information bureau). This project will

finance a range of activities that are necessary to prepare for a major

reform operation. This initial phase will also serve to demonstrate and

confirm broad-based commitment to undertake difficult reforms. This

sequential approach to financial sector reform has been endorsed by

colleagues in the International Monetary Fund (IMF), the Department for

International Development (DFID) U.K., and the Asian Development Bank

(ADB).

The Financial Sector Reform Program is also important in terms of

enhancing poverty alleviation. It is expected to (a) support

private-sector-led economic growth and job creation; and (b) reduce the

number of nonperforming loans made through the banking system to the

politically powerful elite in Kathmandu. As the large non-recoverable

losses in the banking system will have to ultimately be borne by the

Government -- this represents a transfer of resources from the tax payer

in Nepal to the urban rich (who represent some of the largest defaulting

borrowers in the banking system). A more efficient intermediation of

funds should also result in a better allocation of financial resources and

hence stronger economic growth.

3. Rationale for Bank's Involvement

The Bank has a growing background in the area of financial sector reform

operations which will be useful in the implementation of the proposed

Nepal program. The Bank is also a significant source of development

assistance in Nepal and -- in concert with the IMF, DFID, and the ADB --will be able to present a strong case for making the appropriate decisions

and tough choices.

In this regard, project preparation and appraisal has coincided with IMF

and DFID missions which has provided an opportunity for close

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collaboration. Financial sector reform (along with fiscal reform) are

also central tenets of the IMF's support program for Nepal.

DFID's contribution of US$ 10 million equivalent for this joint project

will reinforce IDA's efforts and will establish a track record of

cooperation between our two agencies in the area of financial sector

reform -- for the next phase of the reform effort.

4. Description

The project has three main components (Table below). Based on its

cofinancing agreement, DFID will provide US$10.0 million equivalent in the

form of joint financing for this project. The respective DFID shares for

the three components will be: US$1.56 million for re-engineering of NRB;

US$8.10 million for restructuring of RBB and NBL; and US$0.34 million for

capacity building in the financial sector. The balance of US$4.1 million

will be provided by HMGN.

Re-engineering Nepal Rastra Bank

Restructuring the Two Big Banks (RBB and NBL)

Capacity Building in the Financial Sector

5. Financing

Total ( US$m)BORROWER $4.10

IBRD

IDA $16.00

UK: BRITISH DEPARTMENT FOR INTERNATIONAL DEVELOPMENT (DFID) $10.00

Total Project Cost $30.10

6. Implementation

A Coordination and Support Team (CST) has been formed within Nepal Rastra

Bank under the Banking Operations Department to administer this project.

The Executive Director of the Banking Operations Department heads the CST

and provides overall guidance and leadership on matters of project

implementation. The CST is supported by a dedicated Financial Management

Specialist who is a qualified professional accountant and by a dedicated

Procurement Specialist. The CST is also supported by adequate ancillary

staff and facilities. The operating costs of the CST will be funded under

the project on a declining cost basis over the project implementation

period. These operating costs include communications, office supplies and

materials, incremental staff costs, and other expenses which will be

jointly financed by the IDA Credit and the DFID Grant. Staff salaries are

excluded.

Financial Management (also see Section E - Summary Project Analysis and

Annex 6) A financial management capacity assessment of the implementing

agency, Nepal Rastra Bank, was carried out by World Bank financial

management specialists during appraisal. The project has adequate

financial management arrangements in place to account for and report on

project expenditures. To mitigate potential financial management risks

and to strengthen the financial management capabilities of NRB, a

financial management improvement component has been designed and built

into the project to ensure that noted deficiencies are appropriately

addressed. Terms of reference for consultancy services to help improve

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the accounting capacity of NRB have been agreed and advertised in the

local and international press (including the UN Development Business).

The proposed consultancy services are expected to be carried out in three

phases. The first phase is a diagnostic and planning phase and will

identify the areas that need improvement resulting in the development of a

time-bound action plan to address any weaknesses. The second phase will

implement the agreed actions. The third phase will include intensive

training for NRB staff and a follow-up evaluation of the impact of the

financial management improvement program. These steps will build on the

good initiatives that are already underway within NRB to ensure the

establishment of a robust financial management system. Annual project

financial statements, SOE's, and special account statements will be

audited by the Office of the Auditor General and submitted to IDA within

six months after the end of the fiscal year. NRB entity financial

statements will be audited by a certified private auditor who will be

appointed by the Auditor General and submitted to IDA within six months

after the end of the fiscal year.

7. Sustainability

The sustainability of the financial reform program will depend upon the

commitment of the Government to take hard political decisions on

governance issues in the two large banks. Given the politicization of

these institutions, it may prove difficult to ensure the proper commitment

to lasting restructuring (and ultimately privatization or liquidation)

that is required. Nonetheless, some actions demonstrating government

commitment have already been taken upfront, and the project team feels

that the program has a significantly enhanced chance of success as a

result. The Financial Sector Strategy Statement is thorough and sound in

its approach to fundamental financial sector reform, and it reflects an

appropriate set of policies. An expert management team has also taken

over the management of NBL and a Chief Executive Officer has been selected

to take over RBB -- in all their key functions. Overcoming the political

resistance to the introduction of external management teams already

demonstrates considerable resolve on the part of the government and

increases the likelihood of sustainability of the reform process.

Sustainability could be adversely impacted by political uncertainly within

Nepal. Weak coalitions and frequent changes in Governments, which seek to

curry political favor with their electorate, may result in a policy

reversal. Close cooperation with the IMF, the ADB, DFID and the rest of

the donor community will also be important to ensure that adequate

pressure is brought to bear against any perceived reversal in policy gains.

8. Lessons learned from past operations in the country/sector

The OED Performance Audit Report for the Second Structural Adjustment

Credit (Credit 2046-NEP), May 17, 1995, concluded that: "The basic cause

of the weakness of the financial sector design [in that project] was:

(i) Lack of commitment by the Government to change its basic attitude

towards the state-owned banks, including a much stronger emphasis on

commercial orientation and on preparation for eventual privatization;

(ii) Absence of an Action Program did not require the Government to

introduce drastic changes in the managerial culture to ensure that

managers were professionals with autonomy and accountability; and

(iii) Lack of specific fundamental reforms needed to achieve a major

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improvement in financial and operational performance of the banks."

The current operation has dealt with these lessons by not proceeding with

IDA financing until there has been upfront commitment and action by the

Government to carry out fundamental reforms in banking supervision

generally and in the governance arrangements within the state owned bank

RBB and in NBL, in particular -- starting with the placement of external

management teams in the two banks. The development of an overarching

framework for financial sector reform -- as encapsulated in the Financial

Sector Strategy Statement -- will also help ensure consistency and

commitment.

In addition, generic lessons learned from previous projects in the

financial sector include:

(a) Sustainable banking sector reforms require that the autonomy and

technical skills of the regulator be enhanced. This project aims to

enhance the bank supervisory technical skill of NRB so that it can become

increasingly more professional and autonomous;

(b) Legal framework reforms are critical to ensure successful

implementation. This project has supported the revision and modernization

of key banking legislation. A new NRB Act, providing the Central Bank

with significantly more autonomy, was approved in January 2002. A new

Banking and Financial Institutions Act is currently under discussion

within the banking community. Further legal reforms, including measures

for debt recovery, and registration and prioritization of liens, are also

envisaged in the immediate future;

(c) Sequencing is important for successful financial sector reform.

Strengthening the Central Bank, as anticipated under this project, is a

high priority and should be carried out with a program of initial

commercial banking reform;

(d) Reforms should include rationalization of processes and procedures and

should be backed by vigorous enforcement. The project will deal with

procedures in the Central Bank and will provide assistance to ensure

strict enforcement of prudential regulations and legal requirements;

(e) Reforms should focus on a limited number of key activities. This

project will support a purposely limited agenda of focused activities;

(f) Forcing reforms from outside is not sustainable. Strong borrower

commitment will produce the greatest chance of success. This commitment

appears to be in place as evidenced by the development of the Financial

Sector Strategy Statement, the appointment of a professional management

team in NBL and a professional CEO in RBB, and the ongoing close liaison

between NRB and the Ministry of Finance on all aspects of the financial

reform process; and

(g) Re-capitalizing commercial banks without fundamental reforms in the

ownership and governance structures of the banks is not likely to be

successful. Any injection of capital into RBB and NBL will only be

supported at the point of privatization/liquidation or some other

acceptable change in governance arrangements within these banks.

9. Environment Aspects (including any public consultation)

Issues : The project is rated C for the environmental

impact. No environmental impact is expected under this project.

10. Contact Point:

9

Team Leader

Simon C. BellThe World Bank

1818 H Street, NW

Washington D.C. 20433

Telephone: 202-473 4931Fax: 202-522 1145

11. For information on other project related documents contact:

The InfoShop

The World Bank

1818 H Street, NW

Washington, D.C. 20433

Telephone: (202) 458-5454Fax: (202) 522-1500

Web: http:// www.worldbank.org/infoshop

Note: This is information on an evolving project. Certain components may

not be necessarily included in the final project.

This PID was processed by the InfoShop during the week ending

November 22, 2002.

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